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A Conversation with Dr. Ira Kalish, Deloitte’s Chief Global Economist

The U.S. economy is undergoing deep structural changes in the aftermath of the 2008 financial crisis, according to Dr. Ira Kalish, chief global economist for Deloitte Touche Tohmatsu Limited. Prior to 2008, the country’s economic growth was largely driven by debt-fueled consumer spending and housing investment—a model that proved unsustainable. To recover, Dr. Kalish says the U.S. has to transition to an economy powered more by exports and business investment than consumer spending.

And yet, economic conditions look ripe for a consumer spending revival. Dr. Kalish notes that employment has improved, and American consumers’ household balance sheets are in a stronger position following several years paying down their debt.

Those are among the insights Dr. Kalish shared with Tom McGee, Deputy CEO of Deloitte LLP and national leader of Deloitte Growth Enterprise Services, during a recent Economic Perspectives video webcast. Here’s an edited version of their Q&A, in which Dr. Kalish offers his perspective on U.S. economic growth, consumer spending and the potential impact of changes to the Federal Reserve’s monetary policy.

McGee: What has changed in the five years since the economic crisis began?

Kalish: In some ways, not much has changed. We still have banks that are too big to fail and a large shadow banking system. The government remains involved in the housing market and continues to pursue an even more aggressive monetary policy.

The difference is new regulation. Banks now have to hold more capital and are more closely supervised. There are procedures for resolving failed banks and even non-bank financial institutions. The regulation may slow credit growth and economic growth, but one can argue that the banks and the financial system are a bit safer than they were five years ago.

Kalish: It appears economic growth for 2013 will come in under 2%. The slow growth this year was largely the result of the fiscal contraction that took place at the beginning of the year: tax increases and spending cuts. That had some negative impact on economic activity, although it did have a positive impact on the budget deficit. My expectation for 2014 is that we’ll come in over 2%—maybe around 2.5%.

McGee: How does U.S. growth compare to other industrial economies?

Kalish: We’ve grown faster than other industrial nations, particularly in Europe, because of our response to the financial crisis. For example, we recapitalized our banks to a greater extent than the Europeans. We pursued a more aggressive monetary policy than Western Europe. We didn’t have fiscal contraction until this year, whereas the Europeans have experienced it for several years. The U.S. still has a long way to go, but we’re in relatively decent shape, considering we were on the cusp of a complete meltdown of the financial system five years ago.

McGee: Are there additional measures the country should take in response to the financial crisis?

Kalish: We’ve done the right things; we just have more to do. Part of the problem was that, prior to the financial crisis, too much of our growth came from accumulating debt—debt-fueled consumer spending and housing investment—and it was clearly unsustainable. Now we have to transition to an economy that relies less for growth on the consumer and more on exports and business investment. We’re moving in that direction. Getting there will require further improvements in our productivity and in the functioning of our credit markets.

McGee: Have American consumers changed their spending behavior since the financial crisis?

Kalish: Consumers haven’t changed fundamentally—not the way they did during the Great Depression. At that time, the economic disaster was so significant that the generation that grew up during the Depression saved a lot over their lifetimes because they were so shaken by the experience.

Prior to the financial crisis, a large part of U.S. economic growth was fueled by consumer spending which was, in turn, driven by debt people accumulated against the rising value of their homes. That’s over. Consumer spending has been more constrained, in part because many consumers haven’t experienced much income growth and partially because they’ve put increases in disposable income toward deleveraging [paying down their debt].

That said, the stage is set for a bit of a revival in consumer spending in the next two to three years. We’ve seen a pretty big increase in wealth in terms of equity prices and home prices. The job market is better. Consumers’ financial situations are much improved since 2008, and there is a lot of pent-up demand. Even though their personal incomes haven’t risen much, the balance of cash they have available to spend because they’ve deleveraged is much higher.

McGee: There’s been a lot of debate about when the Federal Reserve will begin tapering its Quantitative Easing (QE) program. What impact will that have on the economy?

Kalish: First, let me explain what QE and tapering mean. When banks cut back on lending and started hoarding cash during the financial crisis, the Fed stepped in, knowing the banks’ actions could result in a shrinkage of the money supply, which is what happened during the Great Depression. [Chairman of U.S. Federal Reserve] Ben Bernanke decided the Fed needed to offset that shrinkage in the money supply, so the Fed engaged in Quantitative Easing, purchasing assets like government-backed securities and government bonds to pump liquidity into the market.

The problem with QE is that eventually the banks will start lending in a normal way. The risk is that the increase in lending combined with QE will cause the money supply to explode and lead to inflation. It’s incumbent on the Fed to, at some point, begin the process of unwinding QE, slowing down their asset purchases, and eventually ending them. At the same time, the Fed has to be very careful in communicating how and under what circumstances it plans to taper and ultimately end QE. Earlier this year, Chairman Bernanke made a seemingly innocuous statement about the Fed tapering asset purchases sometime in the near future, when economic conditions are right. His comment set off a firestorm in the financial markets. Communication of Fed policy has a significant, tangible impact on the economy.

In any event, markets have already priced in the first round of tapering. So when it does happen, it won’t necessarily be damaging to the economy. Going forward, however, the pace and size of tapering will determine the impact on the economy. Interestingly, the Fed has discussed taking offsetting actions to prevent a slowdown of credit creation. This could entail paying less interest to banks for holding cash reserves. The idea would be to encourage more bank lending.

McGee: The federal budget is in better shape. What’s contributed to that?

Kalish: In the fiscal year that just ended, the budget was at about 4.5% of GDP, down significantly from 2009 and 2010, when it was within 10% of GDP. The Congressional Budget Office expects the budget to get below 3% of GDP within two years. A number of factors have contributed to the decrease. This year, we had a lot of fiscal contraction. We had two big tax increases: the income tax and the payroll tax. We had sequestration (automatic spending cuts) and the continuation of spending cuts Congress agreed upon in 2011. We also had much slower inflation of health care, which led to slower growth in the cost of Medicare and Medicaid. The Federal Reserve, Fannie Mae, and Freddie Mac had good profitability, and they return their profits to the Treasury.

McGee: Late last year and earlier this year, there was some momentum to reform the tax code. Lately, though, there’s been less conversation about it, yet lawmakers on both sides believe something should be done. What’s the holdup?

Kalish: At one point, a basic framework for tax reform that both parties might agree upon had emerged, but at this point the momentum behind it has died—for reasons having less to do with the debate over tax reform and more to do with the political standoff in Washington. It’s hard enough to get basic legislation passed. Passing controversial legislation like tax reform is even harder. Hopefully it will get back on the table sometime in the near future because it is vitally important. A good tax reform bill could have a positive impact over the long term on economic growth.

McGee: What most concerns you about the economy over the next 12 months?

Kalish: I’m cautiously optimistic about the U.S. and global economy. I’m not worried about inflation or an economic slowdown. But the seemingly never-ending fight in Congress over the budget and debt ceiling concerns me. Even when they pass a continuing resolution, it just leads to another deadline and another contentious negotiation. I’m also concerned about unwinding QE. The Fed is doing the right thing, but we’ve learned the Fed needs to communicate its position very carefully. And, of course, there are risks from abroad. The degree to which Europe recovers from its doldrums will influence the U.S. economy, as will the speed of reform in China.